The main purpose of an annual report is to tell you how your investment is doing. A company's annual report does this in several ways. The first is obviously the financial statements included in the annual report. These scorecards give you a historical perspective on how the company is performing. A second, and possibly more important, way the annual report helps you understand the prospects for your company is through what is known as Management's Discussion and Analysis (MDA).
MDA is important because, if properly constructed, it gives you a sense of management's feelings about the company. Things like strengths, weaknesses, accomplishments and failures to meet objectives are the stuff of which MDA is made. MDA is also where you get a sense of management's prospects for the future.
So what is included in MDA? Are there certain required items, or can a company just say what it wants? That's the focus of this month's article.
To start off, MDA is required by securities laws. It is considered part of the full and fair disclosure upon which the securities markets are built. To that end, management must cover certain key issues in MDA:
- Capital Resources
- Results of Operations
- Off Balance Sheet Arrangements
Put simply, management is required to tell you how it feels about the company's ability to meet it's obligations as they come due. Just a few of the considerations are:
- Known commitments that will require funds in the near and long-term future.
- Known trends that will affect cash flow.
- Events that may affect the liquidity of the company.
If management expects cash flows to improve materially, then significant added disclosure is not necessary. However, if there will be a material decrease in liquidity, management is required to tell you how the company will deal with the decrease in liquidity. Will the decrease be permanent or temporary? Will the decrease be catastrophic or just a mere inconvenience? How is the company going to provide liquidity to continue operations while in the cash slump? These are the things you should look for in this section of MDA.
Capital expenditures are the company's investment in its own future. They are also a drain on the liquidity of a company. It is important for investors to be aware of planned plant additions or expansions and investments the company is committed to making. At the same time, investors need to know how the company is going to meet its commitments. This type information is important in helping the investor to analyze the company's ability to meet its growth and expansion goals.
Results of Operations
This is the area of MDA where management explains what happened in the prior year. Management is required to provide you with information on any trends or uncertainties that have already or may have a material effect on the income statement. The sources of income and variations in income between years should be discussed, along with the same information for expenditures. The effect of any known increase or decrease in operational revenue and expenditures should also be disclosed.
Off-Balance Sheet Arrangements
Off-Balance Sheet Arrangements are transactions where the company assumes some obligation of future performance, but the specifics of the transaction do not require recording an asset or liability. Management should provide you with the nature and purpose of such transactions and their importance in respect to liquidity, capital resources and operations. If an event has happened that indicates the company will be significantly affected by such arrangements, this fact must be disclosed.
Management's Discussion and Analysis of the company's prior year and current resources can be invaluable in assisting you, as the investor, to evaluate the strength of your investment. Don't avoid it as just another advertising pitch. Should you need assistance in understanding this area of the annual report, please, do not hesitate to give us a call.